I can see the first signs of a return of the euro debt crisis

Financial markets rallied in 2012 and have continued that rally so far in 2013 despite worries over slow growth in the United States and the realities of no growth in Europe and Japan.

Why? Money from the world’ central banks and a belief in the power of those banks to backstop financial assets.

The traditional advice has been don’t fight the Fed. For 2012 that advice broadened into don’t fight the Fed and the European Central Bank. And in 2012 that was good advice as cheap money from the Fed and the European Central Bank and promises of even more cheap money if necessary more than made up for slow growth in the U.S. economy and no growth in European economies. Markets moved up on the central bank guarantee.

But I can see a major test of the belief in that guarantee shaping up around the middle of 2013. The big challenge to the markets this year, in my opinion, isn’t going to be the U.S. fiscal cliff or the battle over the debt ceiling or a continuing resolution to keep the U.S. government going.

We know from past experience that at some point, a market that believes it has a guarantee so over extends itself—the technology stock crash of 2000 and the housing crash of 2006-2007 are good examples—and that then the central bank guarantees turn out to be less powerful than everyone assumed and inadequate to head off the crisis. As I watch money flow back into Spanish and Italian bonds despite the lack of any solution to the underlying problems of the euro, I wonder if I’m watching a replay of that dynamic. I think not. I think the faith in the power of the central banks will weather this replay. But I can’t 100% rule out the possibility of the crisis getting serious enough to rattle that faith.

And with that in mind I think it’s worth taking a look at the shape of the likely replay of the euro debt crisis in an effort to see how much danger it represents to global financial markets.

I think I can make a strong case that we’re headed back to something like the same conditions that roiled markets back in the first half of 2012. I even think it’s fair to say that all the problems that were kicked down the road in 2012 rather than solved are about to return and bite us again in 2013.

What's happened recently to convince me that we’re nearing crunch time in the EuroZone again?

A series of reports and warnings last week that focused on exactly how fragile the recovery in financial markets in Portugal, Ireland, Spain, and Greece might be.

For example, on Friday, the International Monetary Fund said that Portugal had done all the right things to reduce its budget deficit and to reform its economy since it received its 78 billion euro bailout ($103 billion) in May 2011, but that, nonetheless, the country could be thwarted in its goal of returning to the financial markets by September 2013. (Portugal plans to sell 5-year debt in the next few days. That would be the country’s first sale of anything other than short-term debt since the start of the euro debt crisis. And it would put the country ahead of that September timetable.)

The problem, the IMF said, is that economic growth is slowing all over Europe, even in the northern European economies, such as Germany, where growth had held up well during the crisis. Because of that slowdown, the Bank of Portugal said in its own forecast a few days earlier, the recession in Portugal would be worse than expected. The Portuguese central bank had cut its forecast for economic growth in Portugal in 2013 to a contraction of 1.9%. That’s twice as big a contraction as in the bank’s previous forecast.

The story is Italy is similar even if the projected contraction isn’t as severe. Last week the Bank of Italy increased the depth of the contraction it was projecting for the Italian economy in 2013 to a 1% drop. The previous forecast from just three months ago had been for a drop of 0.9%. That’s not a huge change in the size of the contraction but the trend isn’t positive.

How much the increasingly negative prospects for the Italian economy may be a factor in the rising fortunes of former Prime Minister Silvio Berlusconi is debatable, but Berlusconi is clearly rising in the polls. Berlusconi’s right-of-center People of Freedom Party now trails Pier Luigi Bersani’s center-left coalition by just 6 percentage points. That’s a four-percentage point gain in a week. So far, I don’t think the Berlusconi surge is likely to propel the People of Freedom Party to victory in the election scheduled for February 24-25, but it could force Bersani to include current unelected Prime Minister Mario Monti’s center coalition in a new government. That event might actually be reassuring to financial markets that would react negatively to a Berlusconi return. The former Berlusconi government showed little inclination to tackle Italy’s budget deficit or to pass economic reforms. And I’m sure that financial markets would assume that a new Berlusconi-led government wouldn’t do any better. Especially since Berlusconi’s campaign is based on running against German Chancellor Angela Merkel in an effort to tap Italian anger at budget cuts and tax increases. Those policies, he has said, were imposed on Italy by a Germany out only for its own advantage. Even if Berlusconi does indeed lose as expected, the strength of his support isn’t going to make Merkel stronger in her own election position this fall or to incline Germany toward compromising its own opposition to any relaxation of the austerity economics advocated by the country during the crisis.

The recent dose bad news from Spain this past week wasn’t about economic growth—where past news has been grim enough—but about the country’s banking system. In Spain the crisis has always been more about bad bank loans than the government budget deficit and on that front the crisis continues to worsen. In November, the Bank of Spain reported, bad bank loans climbed to 11.4%, a new high, from 11.2% in October. Although Spain continues to be able to borrow at reasonable rates thanks to European Central Bank president Marie Draghi’s promise to defend the euro whatever it takes, all but the strongest Spanish banks are still headed toward the need for even more support from the Spanish government. And with Spanish unemployment at 25%, it’s hard to see how a lot of Spaniards currently teetering on the edge of default on their mortgages won’t wind up going over that cliff.

And then there’s still Greece. The latest report on Greece from the International Monetary Fund concludes, in my reading, that the current austerity program isn’t working. Too many of the rich and the self-employed continue to evade taxes and what the report characterizes as a bloated and unproductive state sector has been subject to only limited cost-cutting. Greece faces a need for either higher tax revenue or further spending cuts to the tune of 5.5 billion euros ($7.25 billion) in 2015 and another 9.5 billion euros ($12.5 billion) in 2016, the IMF calculates. The European Union argues that the actual funding gap is smaller, but Europe’s accountants don't disagree with the IMF’s basic conclusion. I’d carry the IMF’s logic one step further: Greece will not be able or willing to close that gap and the EuroZone will be asked for more money and another bailout. The sums, for far, are relatively small (although likely to get larger as European economists slow in the next year or two,) but I don't think there’s any more patience with funding Greece. And that’s especially the case if the IMF gives the critics of the bailout the ready-made argument that wealthy Greeks are cheating and the Greek government is an ineffective financial steward.

So what happens now? How quickly do we approach a rerun of the euro debt crisis?

The good news is Not very quickly. Spain and Italy, the two economies with problems too big for the EuroZone’s bailout funds to handle, have used the calm following Draghi’s “whatever it takes” promise to prefund a good portion of their debt needs for 2013.

For example, on January 15, the Italian government sold 6 billion euros in 15-year bonds. That was the first time Italy has been able to sell 15-year bonds in more than two years, itself a sign of how far confidence has climbed since last summer. And this brought the total bond sales by the Italian government in 2013 to nearly 10% of its total funding need for the year. 10% in two weeks—that’s a very good start for a year that will be challenging but less challenging than 2012. In 2013, it’s now estimated Italy will need to sell 186 billion euros in debt, a hefty total but still substantially less that the 235 billion euros sold in 2012. The Italian Treasury has been so encouraged by bond sales so far in 2013 that it is now planning an offering of 30-year bonds—when the time is right, according to Treasury sources. Italy hasn't been able to sell 30-year bonds in the market since September 2009.

The story is Spain is also positive although less so than that in Italy. Spain has to sell about 8% more debt in 2013 than in 2012—about 122 billion euros in 2013. So far, as with Italy, the Draghi promise has brought interest rates down and given Spain renewed access to the bond markets. Foreign investors who had shunned Spanish debt before Draghi’s pledge have returned to buy Spanish debt. I wouldn’t call foreign holdings of Spanish debt robust but the level has rebounded from a summer low of 33.86% to 35.44% in November.

I think the good news on bond yields and bond sales from Italy and Spain—and from Portugal and Ireland where those countries have said they hope to return to the bond markets as early as 2013—pushes a return to crisis further down the road. I think optimism about European sovereign debt has the momentum right now, enough momentum to hold until summer, I’d estimate.

After that the date on which the financial markets might see a return of the crisis depends on three factors.

First, how weak will a new Italian government be after the end of February elections? The good will that sustained even the minimal economic reforms that Mario Monti pushed through is largely gone. A weak coalition government will have a hard time convincing the European Central Bank or the International Monetary Fund that Italy’s debt is under control. I don’t think a weak Italian government will create an immediate negative reaction in the bond market but it would be the start of a creeping unease.

Second, how quickly do the finances of Spain’s regional governments deteriorate in 2013? Already one-third of the planned 71 billion euros in new debt that Spain plans to issue in 2013 (the rest of the year’s total consists of re-financing debt that matures) is headed to Madrid’s bailout fund for regional governments. Yes, Spain’s weaker banks are still likely to need further bailout funding, but I think the market already understands that and the bank bailouts that have already occurred have put a structure in place. Regional government debt raises much more troubling issues for the bond markets. We’ve already seen the beginnings of a battle over the subordination of this debt to Spanish national debt with holders of existing regional debt protesting Madrid’s efforts to make this debt junior to the national debt. Regional debt has exposed all the unsettled political questions about the relation of the central government in Madrid to the regional governments. With Catalonia pushing for more autonomy, regional debt could be a flash point for a genuine constitutional crisis in Spain that would unnerve bond markets. I think Spain, more than Italy or any of the smaller peripheral economies, is the likely catalyst for any revival of the euro debt crisis.

And third, will Angela Merkel be able to postpone any action likely to rile German voters until after fall elections in Germany? She certainly will try. The idea of more money for Greece is deeply unpopular in Germany. So is anything that implies joint responsibility for debt. German—and to a lesser degree Finish and Dutch politics--will severely limit what the EuroZone countries can actually do to head off any crisis before it escalates. I don’t think this moves the return of the crisis closer to us in time, but it does argue that effects from the any return to the euro debt crisis would only slowly be addressed. (This is even more likely if, as now seems to be the case, the International Monetary Fund is having second thoughts about the effectiveness of austerity economics.) Negative trends could well gain momentum. In a political vacuum even more will depend on the European Central Bank. Mario Draghi’s promise to do whatever it takes to defend the euro might get tested.

It’s this last factor that most worries me for it, unlike an actual deterioration in the budget deficits of Spain or Greece, has the potential to significantly weaken the market’s faith in Mario Draghi’s promise to do everything necessary to defend the euro.

I can see a political situation arising in Germany where the opposition of the German central bank, the Bundesbank, to further support for the troubled economies and banking systems of Italy and Spain and the rest of the euro crisis countries, threatens Draghi’s ability to deliver on this promise. And I can see a political situation arising in Germany where Merkel’s position is so weakened that she can’t push back against the Bundesbank and where she has to behave like the Germany first leader that so many in Europe fear—wrongly I think—she already is.

And that would change the game in a replay of the crisis. If investors start to think that the European Central Bank doesn’t guarantee the markets and that the solution of the crisis depends instead on European politicians, then I think we’re looking at not just a replay of 2012 but also an escalation of the crisis to something that could significantly damage global financial assets.

I’d say the odds are against that very negative outcome. But I can’t, unfortunately, rule it out.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/